Thursday, 7 February 2013

It is called the "valley of death". While the phrase may seem to conjure up the words of the 23rd Psalm written over two millennia ago ("Yea, though I walk through the valley of the shadow of death"), we are talking about something that is very here and now—the financing of medical R&D. There is a serious disjunction between the advances in medical R&D and the financial environment for bringing these advances to market. In particular, there is a severe funding shortfall at the stage between basic research (which is often government –supported) and when final approval is given. This intermediate stage, with its acute shortfall in funding, is called the "valley of death".

One attempt to address this problem is discussed in January 26, 2013 issue of The Economist ("Financing medical research—disease or cure"?) here. As reported in the article, over the past decade there has been a perfect storm in which the returns of pharmaceutical companies have significantly declined, the stock price of leading pharmaceutical companies has diminished by as much as 50%, and venture capital funding in the field has more or less disappeared. It does not help that a critical mass of new therapies is emerging which rests on gene marker technology and addresses markets with less commercial scope than those enjoyed by the more general block-buster drugs of the past two decades. All of these factors have contributed to the "valley of death" in medical product funding.

What to do? One suggestion, according to the article and which seems to have garnered significant attention, is based on a research paper published last year—"Commercializing biomedical research through securitization techniques"— by Andrew Lo and Jose-Maria Fernandez of MIT and Roger Stein of Moody's. Lo, Fernandez and Stein first describe one approach, namely investing in the royalties of approved drugs (what The Economist calls "a return [to the investor] that has similarities to a diversified portfolio"). This structure is already in effect by such entities as Royalty Pharma, DRI Capital and Cowen Healthcare.
But these authors go beyond this relatively straightforward (conceptually at least) investment vehicle to suggest a much broader approach. The contours of their proposal contain the following elements:

1. A number of so-called "megafunds" in an amount up to $30 billion dollars will be created. These funds will be financed by a combination of equity and that dreaded word from the Great Recession—securitization.

2. Unlike a venture-capital fund (at least in the current form of the industry), these megafunds will not have a short-term time horizon for cashing out its investment.

3. Unlike a mutual fund, the megafunds will hold a lot of illiquid assets, such as "products, patents, licences and royalties", "anything in medical research that may eventually produce a cash flow."

4. If structured "properly", the megafunds will have a high likelihood of success in at least one of the invested companies. The scale and diversity of the megafunds will presumably reduce aggregate risk. As such, the expected returns from such funds will be in line with average returns for holding equity or debt.

5. This structure is intended to result in a more even distribution of investment in medical research, unlike the current situation, which is characterized by a small number of successes, if any, and a large number of commercial failures.

6. In response to comments following the publication of their article, Lo, Fernandez and Stein have suggested alterations to their proposal, including "use of credit-default swaps and government guarantees to encourage investors." [Readers will no doubt recall that "credit-default swaps" and "government guarantees" were two main vehicles that are crediting with leading to the financial crisis in 2009.]

The Economist is not overly optimistic about the actual launching of any such megafund. It seems to me that the underlying question is whether high level financial engineering is really the way to address the problem of medical product funding in general. "Securitization" is still in many popular circles a dirty word. The fact that the investment community fell prey to the dark side of securitization in financing the residential housing market, an industry of long-standing and supposedly well-understood, does not bode well for the inherently more risky and uncertain world of royalty streams from medical developments. I have the feeling that challenges of funding in this area will require more than the most imaginative form of financial engineering to get it back on its feet.

1 comment:

Anonymous
said...

The idea is clearly not new, but the suggested scale of it is impressive. Being honest, everyone in the field knows that medical research is extremely unpredictable and risky. Large pharmaceutical companies are the most sophisticated players in the area, and their track record for predicting what's going to work has been hopeless recently. So there's a real chance that this will fail, but in the short term certain investors may make money if they get out at the right time. I suspect its the naïve investors (pension funds) and of course government(s) that will foot the bill, which perhaps is the real initial intention.